It finally clicked – my light bulb moment

I finally had a light bulb moment after more than four years of learning about personal finance. I’ve been making a fair amount of changes to my portfolio during my blogging absence. And while I’ve yet to post my new asset allocation, here’s one change I’m making which is long overdue. Drum roll, please…

This year I’m going to be maxing out my 401(k) contribution to the full $18,500 allowance in 2018.

There. So what does this all mean and why didn’t I do it earlier?

What is a 401(k) in the first place?

The 401(k) is a retirement savings plan in the US. 401(k) contributions are deductions from your paycheck and which are typically paid “pre-tax”, so they lower your taxable income. Plus your employer usually matches some of your contributions which is free money. Once the money is in the 401(k) account, the investment growth and dividend payments aren’t taxed until when you start to withdraw the money upon retirement.

The downside is that when you start making withdrawals, it’s treated as income and so taxed higher than dividends or capital gains are currently taxed. There are also restrictions on when you can access the money and forced withdrawals once you reach a certain age.

My 401(k) plan

I’m very lucky with my employer’s 401(k) plan. Not only are the investment offered include insanely cheap index funds, my employer contributes 4% of my salary and then matches the next 4% of my contributions. So to get a total of 12% of my paycheck, I need only contribute 4% of my salary.

Now the $18,500 contribution limit for 2018 applies to your individual contributions, and not to your employer’s matching contributions. You can also pay additional individual contributions up to a combined maximum of $54,000, although your contributions after $18,500 are “after-tax”.

How I’ll reach $18,500 this year

I’ve estimated that I need to pay 14% of my salary into the 401(k) to reach the $18,500 limit. Together with the employer matches, this should end up with total contributions of about $28,000.

Over the last four months or so, I’ve been slowly increasing my contribution amounts to see the overall effect of each increase. I started 2017 contributing 8% of my income, then increased it to 12% at the end of September. Over the Christmas holiday I increased it to 14% for the start of 2018.

The effect on my monthly income

Each 1% increase lowered my monthly income by about $75. So this year my monthly net-pay after withholding taxes will drop by about $450 or so. I’m paid twice-monthly and I’m still waiting to see the final monthly amount since there have been changes to the amounts paid for other company benefits.

But essentially, I’ll be investing less each month in my Taxable accounts and increasing the investments in my Tax-Advantaged accounts.

So why wasn’t I doing this before?

Here is the more psychological discussion which I think is more interesting.

Previously I was contributing 8% of my salary, my employer was paying another 8%, for a total of 16%. This felt like “enough”. I then invested the rest in Taxable Accounts using “after-tax” money.

There were several reasons for not contributing more and for investing in Taxable Accounts instead.

I liked the liquidity of having money available if needed in my Taxable Accounts.

I could invest the after-tax money in any investments I chose, including individual stocks.

I justified the “tax-drag” of paying taxes on dividends by comparing the tax-rate on those payments to the tax-rate I’d pay on a cash savings account (15% for qualified dividends vs 28% for regular interest).

What changed?

Each of the three reasons above now have a more rational answer.

I now have enough money in my Taxable Accounts to entirely pay off the mortgage, so I’m not as worried about liquidity any more.

I’m still not convinced owning individual stocks is worth the risk (but I do like buying some from time to time).

Why pay any more taxes than you need to?

plus

I’m looking at the bigger picture of my portfolio across all taxable and tax-advantaged accounts, and improving the tax efficiency of my taxable accounts.

Other valid reasons for not contributing more to a 401(k)

If your employer 401(k) plan offers very expensive investments or a poor selection of investments, it may be better to put any extra money into a Roth or T-IRA instead. But always at least pay enough to achieve any matching employer contributions since that’s free money.

What about the higher taxes paid for withdrawals?

As I mentioned above, to actually start accessing money in the 401(k) the money is treated as income and taxed accordingly. I’ll have to do some calculations to show the differences but I believe it’s a choice between paying a higher percentage on a large number (pre-tax investments), or paying a lower percentage on a much smaller number (after-tax investments). That’s because $10,000 of pre-tax money is the same as $7,200 after-tax – the additional $2,800 of pre-tax money should result in a much larger sum in the future, assuming the same investments are being used.

Plus if I do reach FIRE and am able to live for a couple of years without needing to touch retirement accounts, I can convert some 401(k) money at a much lower tax rate. Assuming the tax laws don’t change in the future anyway.

I also expect that over time, the assets in my 401(k) will shift more towards Bonds which will grow less than stocks and so total taxes will be less.

What’s next?

A logical extension of this line of thought, is to continue contributing after-tax money into my 401(k) plan instead of my Taxable Accounts. This isn’t the same as a Roth 401(k) however. For now I like the flexibility of the Taxable Accounts more.

And in case you were wondering…

Where have I been for the last four months?

I’ve not really been in a mood to write or do much of anything lately. I even lost interest in tracking my finances for a while. Maybe it’s the cold winter. I get that happiness is a state of mind, but for some reason my mind can’t be convinced. But I’m slowly reaching out to the light again and I hope 2018 will be a good year.

Quote of the Day

Walking with a friend in the dark, is better than walking alone in the light.

Thanks Erik! It’s great that you’re maxing out your 401(k) this year – it’s definitely a good move and will pay out in the long term.
Happy New Year – I hope 2018 is a great year for you!
Best wishes,
-DL

Good job aiming to max out 401(k) definitely a good idea if your situation allows for it. How do the after-tax contributions work after maxing out 401(k) already and why is that beneficial over say a traditional IRA or Roth IRA. I hope to max out this year!

Good question about the after-tax contributions.Pre-Tax Traditional IRA and After-Tax Roth IRA contributions are restricted once your income reaches a certain level (different amounts for being single vs married). In my case I’m not able to make tax-deductible T-IRA contributions, or any Roth IRA contributions.

I could still make After-Tax T-IRA contributions up to $5,500, which can be later converted into a Roth-IRA. This is the so-called “Backdoor Roth”. I’ve done this in the past but now I would be taxed on the conversion since I have Pre-Tax money in my T-IRA.

So the After-Tax 401(k) contributions are better in general than After-Tax T-IRA contributions in that the contribution amounts are higher. These After-Tax contributions are held separately in the 401(k) accounts and can be later rolled into a Roth IRA by paying taxes on the gains.

Hi DL… I’m a first time visitor. Sounds like you’ve got a terrific 401(k) plan at work. I’d try to max it out as well.
My pre-tax/post-tax retirement savings split is currently about 65%/35%. I like the flexibility this should offer me in the future with regard to generating income while managing taxes. My dividend portfolio is in a taxable account, too, as I plan to have this provide some income once I quit working prior to a normal retirement age. Take care.

Hi Engineering Dividends,
My 491(k) is very good with some very low cost institutional funds from State Street, e.g. the large cap index has an ER of 0.003%.
Hedging in terms of pre & post payments is definitely a good plan and makes a lot of sense – who knows what the future will bring regarding taxes and having options is always better.
Thanks for stopping by and I wish you all the best on your journey to FI!
Best wishes,
-DL

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